🙋 Student Questions and Answers

Click here to learn about timestamps and my process for answering questions. Section agendas can be found here. Email office hour questions to robmgmte2700@gmail.com. PS1Q2=“Question 2 of Problem Set 1”

Questions covered Saturday, Feb 24

How do we treat capex?

🕣 12:59
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✔ A large capital expenditure is either treated as depreciation on the Income Statement and as Capex on Statement of Cash Flows. Capex itself doesn’t show up on income statement, and Depreciation is added back on the Cash Flows statement to remove the effect that is carried forward from the income statement.

How do we treat net working capital?

🕣 12:58
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✔

Payback period and NPV

❔ answered along the way
✔ Completely ignore required payback period when calculating NPV.

PS3Q9

❔ In the year 0 cash flows, do you include taxes in your calculation for the free cash flow amount that year?
✔No taxes in year 0

PS3Q12

❔ When do they promote the new candy line? Year 0 or is that per year?
✔ Year 0

Questions covered Monday, Feb 26

PS3Q1

🕣 7:40
❔ When calculating NPV for a service, I am a little confused on how to define the PV of the inflow, since it is just payments out. Would the inflow be the “value” of the service?

✔ In question 1, the fact that the contract is “worth” $1 million per year, means that the firm is paid $1 million per year for providing the service. Those payments that they receive are cash inflows.

PS3Q2

🕣 7:42
❔ For question 2, what are the problems’ expectations about how signs should be entered?

✔ For question 2, it is asking for the NPV. NPV is always PV Inflows - PV Outflows. If PV Inflows > PV Outflows then NPV will necessarily be positive. If PV Inflows < PV Outflows, then when you subtract them, youll find that NPV will be less than zero (ie negative).

Sign is a very important part of NPV. Clearly, if a project has an NPV of $1M, that is very different from a project that has an NPV of -$1M. You must enter the sign correctly for any NPV. If there are only costs (and no revenues) then the NPV will necessarily be negative.

PS3Q8

🕣 7:48
❔ It gives the earnings and depreciation. But the wording was not clear for me. It says “this includes the effects of depreciation” Does it mean depreciation is already built in the earnings value or that is the value we should consider for the problem?

✔ Roughly speaking, it means that depreciation has already been factored into the calculation of incremental earnings.

PS3Q8

🕣 7:48
❔ Is pro forma earnings the same as unlevered net income?

✔ Effectively, yes. The nice thing with these terms is that you can essentially break down the phrase.

Pro-forma means that they have the form of an earnings statement (or SoCF etc) but they aren’t real financial statements, meaning that they represent a hypothetical outcome - such as the possible outcome that might occur if a given project was undertaken. Basically, it means “imaginary.”

Therefore “pro forma earnings” means “what we think earnings would be”

Unlevered net income means net income, ignoring any leverage. Remember, leverage = debt, so unlevered net income is what you get when you calculate net income when you ignore any interest costs.

In the pro-forma earnings calculations we do, we will typically calculate “unlevered net income” because of how we will be using those earnings calculations. Specifically, when we are doing capital budgeting, we essentially completely ignore interest costs. We do this because we want to separate financing from operations. In other words, we separate financing=liabilities&stockholder equity from operations=assets. We do this because all financing costs (including debt) will be factored into our calculations of the discount rate. Thus, manually accounting for financing costs when we are calculating pro-forma earnings would be double counting.

PS3Q13

❔ I think I need one more step to apply the concept of cash flow effects from the change to NWC.
✔ If the change to NWC is positive, that means the cash flow effect decreases/ minuses.
If the change to NWC is negative, that means the cash flow effect increases/adds in.

❔ Could you please tell that I am applying the concept correctly? Am I heading to the right direction?

✔ You are absolutely right that if change to networking capital is positive, the effect on free cash flow will be negative. Remember, if a company has to increase the amount of stuffed animals it keeps in its warehouse, that will increase inventory and therefore net working capital. This will decrease the amount of free cash the firm has. Tying up cash this way is costly to the firm, and it is represented by decreasing the free cash flow.

Likewise, as you note, if the change in networking capital is negative, then the effect of this is that FCF will increase.